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Increasing income inequality

Quite abruptly income inequality has returned to the political agenda as a prominent societal issue. At least part of this can be attributed to Piketty’s provoking premise of rising concentration at the top end of the income and wealth distribution in Capital in the Twenty-First Century (2014), providing some academic ground for the ‘We are the 99 percent’ Occupy movement slogan. Yet, this revitalisation of inequality is based on broader concerns than the concentration at the very top alone. There is growing evidence that earnings in the bottom and the middle of the distribution have hardly risen, if at all, during the last 20 years or so. Incomes are becoming more dispersed not only at the top, but also more generally within developed countries.

We should distinguish between increasing concentration at the top and the rise of inequality across the entire population. Even though both developments might take place simultaneously, the causes, consequences, and possible policy responses differ.

The most widely accepted explanation for rising inequality across the entire population is so-called skill-biased technological change. Current technological developments are particularly suited for replacing routine jobs, which disproportionally lie in the middle of the income distribution. In addition, low- and middle-skilled manufacturing jobs are gradually being outsourced to low-wage countries (see for instance Autor et al., 2013). Decreasing influence of trade unions and more decentralised levels of wage coordination are also likely to play a role in creating more dispersed earnings patterns.

Increased globalisation or technological change are not likely to be main drivers of rising top income shares, though the larger size of markets allows for higher rewards at the top. Since the rise of top income shares was especially an Anglo-Saxon phenomenon, and as the majority of the top 1 per cent in these countries comes from the financial sector, executive compensation practices play a role. Marginal top tax cuts implemented in these countries and inherited wealth are potentially important as well.

So should we care about these larger income differences? At the end of the day this remains a normative question. Yet, whether higher levels of inequality have negative effects on the size of our total wealth is a more technical issue, albeit not a less contested one in political economy. Again, we should differentiate between effects of increasing concentration at the top and the broader higher levels of inequality. To start with the latter, higher dispersion could incite people to put forth additional effort, as the rewards will be higher as well. Yet, when inequality of income disequalises opportunities, there will be an economic cost as Krugman also argues. Investment in human capital for instance will be lower as Standard & Poor’s notes for the US.

Coins on a scale, © asafta, via iStock Photo.

High top income shares do not lead to suboptimal human capital investment, but will disrupt growth if the rich use their wealth for rent-seeking activities. Stiglitz and Hacker and Pierson in Winner-Take All Politics (2010) argue that this indeed takes place in the US. On the other hand, a concentration of wealth could facilitate large and risky investments with positive externalities.

If large income differences indeed come at the price of lower total economic output, then the solution seems simple: redistribute income from the rich to the poor. Yet, both means-tested transfers and progressive taxes based on economic outcomes such as income will negatively affect economic growth as they lower the incentives to gain additional wealth. It might thus be that ‘the cure is worse than the disease’, as the IMF phrases this dilemma. Nevertheless, there can be benefits of redistribution in addition to lessening any negative effects of inequality on growth. The provision of public insurance could have stimulating effects by allowing individuals to take risks to generate income.

How to leave from here? First of all, examining whether inequality or redistribution affects growth requires data that makes a clean distinction between inequality before and after redistribution across countries over time. There are interesting academic endeavours trying to decompose inequality into a part resulting from differences in effort and a part due to fixed circumstances, such as gender, race, or educational level of parents. This can help our understanding which ‘types’ of inequality negatively affect growth and which might boost it. Moreover, redistribution itself can be achieved through multiple means, some of which, such as higher heritage taxes, are likely to be more pro-growth than others, such as higher income tax rates.

All things considered, whether inequality or redistribution hampers growth is too broad of a question. Inequality at which part of the distribution, due to what economic factors, and how the state intervenes all matter a great deal for total growth.

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